Capital Markets Outlook  |  Q1 2018

Solid growth creates challenge for central banks

Fixed income and currency insights

Solid growth creates challenge for central banks

The acceleration in global growth witnessed in 2017 will continue well into 2018, we believe, but with significant changes in its components. The U.S. economy appears poised to do better than its recent solid pace. Europe and Japan may improve relative to the United States as 2018 unfolds. Meanwhile, the United Kingdom may be headed toward a softer version of Brexit as a consequence of recent developments in the country's efforts to separate from the European Union. Overall, we expect reasonably solid global growth, continued policy tightening by the Fed, relatively benign inflation, and a generally supportive environment for risk-driven assets. We also think bond yields may continue to drift higher over the course of 2018 as rate normalization continues.

The Fed will be a key focus of investor attention as a new chairman takes office and new governors join the Federal Open Market Committee. While we don't anticipate significant policy changes under the new Fed chairman, we do see the potential for communication snafus as the market adjusts to the tone and language of a new leader.

U.S. growth may accelerate with help from tax cuts

There are no obvious downside risks to the U.S. growth pattern, but there are some upside risks, including the labor market, corporate investment, and the effects of the tax reform completed in December. At the margin, corporate tax reforms could buoy the equity markets by raising after-tax earnings, and investment projects that are currently not viable could become more possible with a lower tax rate. The household tax cuts will likely have little impact on consumption because they are, in net terms, very small and geared toward high-income households. But the rally in equity markets creates a wealth effect, and this will boost consumption growth in 2018. The labor market is key to household income and spending, and it continues to improve, albeit at a slower pace.

China turns to restructuring

China avoided a sharp downturn in 2017, but in 2018 the pace of domestic reform may accelerate, with greater emphasis placed on forcing the restructuring of state-owned enterprises (SOEs). The outcome of this restructuring effort depends on whether Xi Jinping, who has consolidated political power, can overcome the strong links between the SOEs, the ruling party, the People's Liberation Army, and a handful of leading Chinese families. Restructuring could slow the economy, and anything that destabilizes internal debt markets creates the risk of a more significant downturn.

The biggest risk is the Fed moving too aggressively

With the real economy likely to do a bit better in 2018, the Fed has legitimate concerns about the possibility that inflation will tick higher. But the longer-term trends in the economy suggest that higher rates are risky. The impact of demographics, the persistent effects on consumer behavior as a result of the financial crisis, the disinflationary impulse from the pattern of global competition and technological innovation, as well as high levels of corporate debt — for all of these reasons, we think the capacity of the economy to deal with much higher interest rates is limited.

The dollar may rally a bit longer

The U.S. dollar outlook continues to be most heavily influenced by the Fed and Congress' surprising ability to deliver a tax reform package. At its December meeting, the Fed hiked rates by 25 bps, as largely expected by the markets. The market is pricing another 50–60 bps in hikes in 2018, a level still a little below the Fed's economic projections, or "dots" outlook, but this gap has closed quite a bit over the past several months. With Jerome Powell approved by the Senate Banking Committee to be the next Fed Chair, it suggests policy continuity over the medium term. Over the coming months, the tactical U.S. dollar rally may continue, though it has already started to wane as the dollar is quite rich.

The euro appears stable

The outlook for the euro remains dominated by relative monetary policy, better-than-expected growth, and a diminished euro political risk premium. The ECB continues to balance the doves, who point to tame core inflation rate, with the hawks, who call for tapering and then ceasing asset purchases. The euro has already moved considerably, so much of the near-term direction will be based on whether the ECB is dovish or hawkish relative to the Fed.

Brexit negotiations to influence the pound

In the United Kingdom, the discussions over Brexit remain fluid and quite noisy, contributing significant volatility to the British pound. Unless there is a breakthrough in negotiations, this volatility is likely to persist. The statements from the Bank of England have been surprising. The BOE has hiked rates for the first time in ten years (by 25 bps) and backpedaled on expectations suggesting that only a couple of hikes would be necessary over the coming three years, putting the fate of the pound firmly back onto Brexit negotiations.

Yen to remain soft as capital leaves Japan

With Prime Minister Abe's landslide victory in the October election, the tail risk of the end of "Abenomics" has been dramatically reduced. BoJ Governor Kuroda continues to underscore that the inflation outlook remains subdued and, as such, the market should not expect any change in BoJ policy, adding that there was no need to raise rates just because foreign rates rise. The dollar-yen rate will remain a function of Fed policy and the long end of the U.S. Treasury yield curve. With financial market volatility low, the yen should continue to soften as capital leaves Japan to be invested in higher-yielding assets abroad.